Download Chapter-3 Mastering Personal Finance

Chapter-3 Mastering Personal Finance
CHAPTER- 3
MASTERING PERSONAL FINANCE
“What sculpture is to a block of marble education is to the soul.”
Outline of the Chapter
3.1
3.2
3.3
Introduction
Factor That Influence Financial Planning
Reviewing and Revising
3.1
Introduction
In the first lesson we will look at the ‘hierarchy of goals’ a hierarchy is a system of ranking thing
in order of priority. When we build a hierarchy of financial goals, we take all of the identified
goals; we then decide which one is the most important, then the next in importance, and so on,
until all the goals are placed in the most sensible order, creating the hierarchy
Life is series of events, some of which we can plan for, and some of that we can’t. You can be
more certain of retirement from work than you can be winning the lottery! We can therefore,
breakdown our life into a series of events, where our needs, goals and priorities will change as
we get older. In this lesson, you will learn about:a. The basic hierarchy of financial goals
b. What needed when!
c. Expected and unexpected events
a.
The Hierarchy of Financial Goals
If you are currently looking for the job, your financial priority is probably to keep a roof
our your head and to put food on the table. If you are starting your career after
completing college or a technical school, your priority is most likely to be paying of debt
you built up while studying. And if you are coming to the end of your career you are
probably most concerned with building your retirement fund.
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So all things considered, what is the basic hierarchy of financial goals? Take a look on
the below mentioned chart where we have listed a number of possible financial goals. At
this stage they are not presented in any order of priority.
Priority
1
2
3
4
5
6
b.
My Hierarchy
Paying of debt
Emergency fund
Protection
Buying a home
Disability income insurance
Other savings
What needed when!
You need to place these goals in order of priority. That mean the most important goals,
relevant to your life stage, should be placed at the top. In the middle of your life this may
be more difficult, as you may think that all of the goals share equal priority. It is
important to understand that there is always an order of priority which changes as your
life changes.
Why is this hierarchy important? You will probably have a higher income in your 30’s
and 40’s than you had in your 20’s, or you will have in your 70’s also, the demand on
your money will change. In your 50’s and 60’s you may not still be considering buying
your first home, and any children you may have could be financially independent.
So, the hierarchy needs to change to take account of the changes. The order of priority
will be changed as you progress in life. For example, you no longer need to worry about
disability income insurance after you have retired, but you may still be paying off your
debts, if you failed to make this a priority earlier in your life.
Exercise
What is your personal hierarchy of goals, right now? Take a little time to complete this
exercise. Get a pen and paper and right down the basic hierarchy of financial goals. Then,
rearrange those goals in your order of priority. Do this right now!
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c.
Expected and Unexpected Events
Life has a habit of surprising us. Perhaps, that surprise might be winning a lottery ticket,
in which case you will have diffident financial concerns! Perhaps, that surprise might be
a new job. Which pay a salary high enough to allow you to obtain a mortgage, and
purchase your first home.
After completing the earlier exercises, perhaps the surprises are that you have discovered
that your debt will spiral out of control if you do not take action! Perhaps, you have been
laid off, been diagnosed with an illness, which mean you can no longer work, or perhaps
you may die prematurely. All these are very possible events in a regular life.
You should list all of the possible events which could be considered unexpected; jot them
down on a piece of paper. Perhaps, you should concentrate for the time being on
unexpected events such as losing a job or illness.
Title this list: unexpected events
Next, consider the potentially expected events which would have an impact on your
finances: buying a house, raising a family, sending children to school or retiring. Try hard
to list all of the possible events that you might expect throughout life. Jot them down on
your paper.
Title this list: Expected events
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The above mentioned two lists will contain very difficult events but such event is
important in financial terms. Now take each event on your unexpected list, and consider
the consequences of not planning of them. Take losing a job for example, the
consequences of this may include being unable to pay your rent and you may be evicted.
Next, each event in turn and consider how you might plan for it. Start with dying
prematurely for example. This is an easy one; you can take out of life insurance, which
will provide your family with some money, in the event of your death. Consider that
there may be a variety of ways that certain events, such as retirement, can be dealt with.
You could try to the save the equivalent of a few months’ wages to help you maintain
your standard of living while looking for a new job. Unemployment payments or welfare
checks may offer some supplemental help, but you should try not to solely rely on them.
3.2
Factor That Influence Financial Planning
Hopefully you now understand how your personal financial goals need to be modified as your
life progresses. The choices if financial products available for these various goals and events will
be influenced by your assessment of priorities at each stage. This lesson looks at the different
products and factors which will influence your financial plan.
In this section you will learn about:3.2.1 The guiding principles that support successful financial planning.
3.2.2 The range of financial products available to make your financial plan a reality.
3.2.3 The personal factors which influence your financial planning.
3.2.4 The external factors which will influence your plan.
3.2.1 The guiding principles that support successful financial planning.
In this lesson we will focus on financial products. These products are tools to achieve
your financial goals. Unfortunately, many people misuse the debt tools. Often, they do
not realize that the underlying cause of their need for debt can be avoided. So let’s review
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a few basic principles that you will need to guide your use of financial products in order
to achieve your financial goals.
a.
Spend less than you make
A lot less! A wise person once said, “It’s not that what you make that matter- it’s what
you keep.” This is why creating and following a budget is so important. Learn to ell the
difference between need and want. You need food. However, you want shrimp, steak, and
a bottle of wine for dinner each night.
Ultimately, this is an exercise of self control and deferred gratification- which run counter
to society’s materialistic and ‘consume now’ mentality. Believe it or not, many
billionaires do not drive a Mercedes and live in a mansion.
Many who have achieved financial freedom done so with hard work, a little luck, but a
lot of discipline and frugality. Sure, you may never be billionaires, but you can still save
your way to achieve your financial goals, including a comfortable retirement.
b.
Pay yourself first
Set a saving goal. 10 % of your income is a good place to start. One of your first saving
goals should be to build that emergency fund (3 to 6 months worth of expenses) all of the
financial experts talk about.
This amount will give you a cushion if you lose your job or the hot water heater breaks.
Instead go paying by credit; you can pay from your emergency fun- avoiding the finance
charges and interest associated with the debt. Once you have emergency fund in place,
turn your eyes to retirement and other saving goals.
Get health insurance coverage
Check into any state sponsored insurance for yourself and your children.
Get out of debt, stay out if debt
Other than a mortgage and/or necessary and manageable business loans, you are
generally should avoid debt when it comes to money, you are either paying interest or
earning interest. Guess which one will get you closer to your goals?
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c.
Don’t be greedy
The old saying “ a fool and his money are soon imparted,” is unfortunately very true.
There will be many people telling you that if you invest with them, you will have the
potential to be rich in a few years. They may be telling you the truth. What they are not
telling you however, is that with such great promise of reward there is an equal
possibility of losing it all. you will need to take some risk to achieve your financial goals,
but if you don’t allow greed to motivate you, you can reduce that risk considerably.
d.
Use debt wisely
Debt should finance true emergencies and needs that you cannot pay out of saving, like a
new roof or a used car; or the purchase of long term investments, like a house or
business. It should not be used to finance short term wants such as vacations, new
clothes, or plasma-screen TV. Debt like this is the enemy that will prevent you from
achieving your financial goals.
You will see the six principle reflected throughout the rest of the module. It doesn’t
matter how much money you make. Following principles will help you achieve your
goals.
Remember!
There are people making Rs. 10,0000/- a year but living pay check to pay check. But
there are people making Rs. 50,000 a year who are saving and investing their way to their
dreams and goals. How much you make matters some but how much you keep matters
most.
3.2.2 The range of financial products available to make your financial plan a reality.
Now that you understand the guiding principles for using financial products, we will take
a look at the various types products available to help you attain your financial goals. The
most important type of financial products for achieving your financial goal are those
related to savings and investing. We will start with a quick review of saving accounts and
certificates of deposit and then move on.
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a.
Savings account
We have mentioned savings accounts already. These are provided by banks and other
financial institutions. You deposit your money into a savings account. The bank uses this
money to give short term loans to other customers. In return, you receive interest and you
can withdraw your fund at any time. Typically the interest on any savings account is
higher than interest-bearing checking accounts but lower than the rate you can earn in a
certificate of deposit. A savings account is a good place to keep your money while you
are saving to meet the minimum investment amount for other investments such as CD or
Money Market Mutual Fund.
b.
Certificate of Deposit
With a CD you give the financial institutions your money (usually a minimum amount
such as Rs. 500 must be invested) for a specified amount of time (usually for a period
between 3 months and 5 years) and in return you receive a specified rate of return higher
than that offered by a savings account. The trade off is that your money cannot be
withdrawn early without a penalty.
c.
Money Market Mutual Funds
These products are offered by various financial institutions. When you give the
institutions your money, they take it and invest it in short term debt. Think of it as getting
together with hundreds of thousands of other people and loaning money to corporations,
banks and the Federal government.
Interest rate on money market mutual funds are typically higher than a bank savings
account and may even be equal to those of CDs but with the advantage of not locking
your money for a longer period of time.
When you have accrued enough money to meet the minimum investment amount of your
money market mutual fund, you should consider moving your intermediate and short
term savings (money you won’t need for a year or more) to these accounts. While they
are not insured by the FDIC, they are relatively safe investments.
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d.
Investment Vehicles
Rather than attempting to describe all the different types of investment vehicles out there,
we will talk about the two main categories- Debt and Equity.
With debt instrument, you lend your money to a corporation or government either
directly or more commonly through a mutual fund. As with all debt vehicles, you are
compensated by earning interest. Example of debt instruments include corporate bonds,
municipal bonds, treasure bills and so forth. On the other hand when you purchase an
equity instrument such as a stock, you are an owner. Again, this purchase may lead to
direct ownership (if you purchase shares of a mutual fund).
The easiest and perhaps safest way to get started with investment vehicles is through
mutual funds. A mutual fund is made up of equity and/or debt security of many different
entities (government or corporate). The mutual fund price is like that of a stock
fluctuating with the change in the prices of securities it holds. We’ll get into more detail
about this in a later module.
e.
Loans
Personal loans can be a short term form of finance. They are usually provided by a bank
and they are many variations available. The term of the loans ranges from one to as many
as 25 years. However, as a short term source of finance, 3-5 years is probably an average
term. Loans can be secured usually with property or unsecured for a short term loan.
Loans can also be insured against a loss of income by paying an additional charge.
Interest is paid to the bank and the rate of interest varies with the product. To find out
more about loans and interest rates, visit the website of any bank or walk in off the street
and speak to one of the customer service employees in person.
f.
Credit
In the context of life plan, credit should be considered a very short term source of finance
of last resort. The credit card is perhaps the best known form of the credit, and its use
(and abuse) is widespread. The credit card is an excellent payment tool, in that it can be
used in many retail outlets, over the phone, and via secure payment systems on the web.
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Be very wary of the convenience of buying with a credit card as its ease of use can
deceive you into buying items you don’t need. A credit card can be cheap form of credit
in the short term, if you clear the balance monthly. It’s a dangerous thing to go shopping
with however, as it allow you to create large debt quickly!
The bottom line with the credit card: use them (with great caution) but pay them off each
month. If you don’t have the cash for an item that is not dire necessity, do not charge it!
The best way to approach the big ticket item is to save extra money- above the 10 % you
are saving to build your emergencies and then your retirement- in your saving account
until you have then cash to cover the purchase.
In this way you can avoid high interest rates associate with credit cards and avoid paying
lot more for your prized them. Then, credit card debt is saved for those (hopefully) few
and infrequent times you absolutely need them. (With an adequate emergency fund, this
should be almost never!)
g.
Mortgage
A mortgage is a long term loan. It is usually used to fund the buying of your home. The
repayments are usually spread between 15-30 years. The borrower can decide to pay back
their loan in a short term time as their circumstances change. The borrower has to also
prove the ability to maintain monthly payment for the terms.
The borrower’s income is considered and a multiple of annual salary is usually offered.
This figure is sometimes even 4 or even 5 times the annual salary but debt can vary and
joint income can also be taken into account. Use great caution when deciding how much
of your mortgage you can afford. The amount the lender is willing to lend will also be
more than you can afford while still financing other financial goals.
Make sure you factor in all of the costs of home ownership. When you own a home, you
will have to pay real estate taxes (local governments, school districts and country
government all raise revenue through real estate taxes.) In addition your utility costs will
be greater especially if you are moving from an apartment into a single family dwelling
and don’t forget about repair for when things break.
The more you are paying in the housing costs, the less money you will have for other
important goals, especially retirement.
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h.
Insurance
Think of insurance as a defense. In any team sport, you win by scoring a lot of points and
holding your opponent to a few points. Financially, it’s the same. You need to save
money but you also need to protect what you save as well. That is what insurance does; it
protects you and your family from the unexpected.
Sometimes, certain types of insurance may be mandated by the government, as with
insurance on your motor vehicle, or by a lender, as with home owner insurance. But more
often than not, you will need to proactively decide your need coverage for a particular
risk and buy it for yourself. See the list below for more appropriate risks to consider

Health Insurance
You are covered for doctor’s care, hospitalization and/or prescription drugs needed in the
event of an illness or accident (as stated earlier, don’t go without this coverage).

Disability Income Insurance
You receive a percentage of your income each month if you are disabled.

Life Insurance
Your loved ones receive the insurance amount tax free so that they can make ends meet
in your absence. Insurance is such a huge area; it would benefit you to look up the
various products on the web.
3.2.3 The personal factors which influence your financial planning.
Now that you are familiar with the products which can help you create a financial plan, let’s take
a look at which personal factors are important influences on that plan. The first of these factors is
your adjusting resources or assets. Let’s take a closer look at the resources.
The resources to be considered are:
a.
Income
How much money is coming in?
Are you likely to maintain that level, and if so, for how long?
b.
Savings
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Do you have short term savings?
Do you have any savings at all?
Do you have a medium to a long term savings plan?
Benefits and Tax credits:
What is your tax position? Do you pay standard or higher rate tax?
c.
Your Existing Financial Products:
Do you have any long term savings or investments?
Do you have a retirement account?
Do you have any shares of stock?
Once you have figured out what your current resources are, the next factor to consider is
time. When saving for retirement time is vital. If you start early and save for a long time,
your monthly contribution could be quite low. Starting later in life would mean you
would have to make bigger monthly contribution to receive the same pay out.
If your goal is to create an emergency fund, then the time still could be very short. If you
intend to save in order to fund your children’s college education, then the time available
to build this fund is a major factor. Remember, the key is to start early. In speaking about
time, we should distinguish between short, medium and long term.
d.
Health and Lifestyle
This can be very significant in influencing a financial plan. Remember the two characters
we spoke about before, Ram and Ramesh? Health is certainly a considerable influence in
financial planning for these two especially when insuring against unforeseen events.
Considering lifestyle, some people find it hard to limit their spending to needs and
occasional wants. Lifestyle debt is caused by buying a flashy motorbike or simply buying
small treats too frequently. Depending on your life stage, a glamorous lifestyle maybe
important to you. But Remember! Life is about trade-off. Spending money for todays
wants means it’s not available to pay for tomorrow’s needs.
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3.2.4 The external factors which will influence your plan.
As you have learnt, events can occur which are beyond your control. These events range
from changes of government to your country going to war. Changes in the economy are
particularly important as inflation, economic growth, and interest rate can affect your
financial plan.
a.
Planning and Practice
In this lesson our attentions turns to the practical planning required to meet a selection of
common financial goals. You need to be able to define your financial goals, assess how
much money is required to meet them, and identify products to help you achieve these
goals. The various goals that we will look at in this lesson are:
1. Creating an emergency fund
2. Managing debt
3. Insurance and Protection
4. Short term savings.
b.
Emergency Fund
The first priority is to create an emergency fund to cover any unforeseen financial events.
This way you can avoid using credit to cover the unexpected, which is always more
costly to you. Estimate what size your emergency fund should be, and how quickly you
can build up the required funds. Remember that building and maintaining the fund is an
ongoing activity.
How much should the fund be? Financial experts suggest 3-6 months of living expenses
(not income) in the long term. That may sound like an insurmountable task. One method
is to take a 3 step approach.
Step 1:
Put all other goals on hold until you have Rs. 1000 in your emergency fund. If you have
credit or loans, pay the minimum payments.
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Step 2:
Once you have reached the Rs. 1000 goal, you can begin to look at funding other goals
such as debt reduction and retirement, by reducing the amount you are allocating to your
emergency fund. And finally,
Step 3:
When you have reached your final goal amount (3-6 months of expenses as a starting
point) you stop contributing to the fund. If you have to use it, you will have to replenish
the amount you used.
A suitable product for an emergency fund is a simple savings account. High interest
accounts usually has withdrawal penalties attached to them, some require that you lock
up your money for a set period. These types of accounts would be useless, as you cannot
easily get your money back. You need easy access to the fund in case of an emergency.
c.
Managing Debt
Regardless of the causes of debt, it has to be reduced or eliminated if you are to achieve
good financial health. It is important to mention that some debt such as mortgage is
designed to be paid off over a longer period of time. Therefore, focus on reducing or
removing more urgent short term debt. The types of debt you need to be concerned with
are debts that appear to be stuck on your monthly budget sheet. These debts could be:
1. Debt incurred for urgent and necessary expenses
2. Credit card debt
3. A large overdraft
4. Multiple small loans
5. Student loan and
6. General lifestyle debt
Each of the debts listed requires slightly different treatment. You will have to understand
the basics and then apply your understanding to deal with the debt. The most important
step you take is to make the removal of all the debts a top priority. Secondly, you should
remove the debt in the cheapest and most effective way possible.
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Your first job is to define the goal. For example the goal could be to clear a student loan.
You should target a specific debt, prioritizing them as you go
You may be able to consolidate your debt into one. Add up how much you owe, and
work out what is costing you per month to make the payment on this debt. Decide how
much you wish to borrow to remove this debt, and over what time period. Find out what
the monthly repayments are. This consolidation will reduce your outgoings into cash flow
and eventually repay the debt.
d.
Next, Financial Products that you can use to Repay the Debt
If you are consolidating your debt, you will need a short term loan, not more than five
years, less if possible. Shop around to find the lowest interest rate you can. Also, avoid
loans that have penalties for early repayment. With a flexible loan you can always make
larger repayments later on.
When you are dealing with a few different credit and loan balances, the basic strategy is
to pay the minimum on all balances. Put any extra payment to the one with the highest
interest rate. Your goal is to pay that down faster, saving yourself some money in the
process.
e.
Insurance and Protection
There are a wide range of insurance products available to help you recover from life’s
unexpected events. As stated earlier, some insurance products are mandatory such as auto
insurance and home owner insurance. Others, you will need to decide for yourself
whether you need and can afford to purchase them.
Insurance can be complicated. It is helpful to have someone who can explain things to
you and help you obtain the greatest value for your premiums. Therefore, when it comes
to insurance, finding a trusted advisor is the best policy. Ask people you know and trust
who they recommend in order to build a list of potential insurance agents and brokers
with whom you can do business.
f.
Short Term Savings
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Short term savings is a very important part of financial planning. Lets say you want a
vacation, you could borrow the money to fund the vacation. But remember, borrowings
have to be paid back with interest. A Rs. 2000 vacation will cost you more than Rs. 2000.
It is never wise to borrow to pay for consumable items like an expensive dinner,
entertainment or a vacation. Instead, you should consider saving for such events. The first
thing you should do is decide what you want to save for and prioritize. Then identify the
generic products that will allow you to save. Savings accounts are the best if you will
want to get the money quickly. High interest is of less importance, because you are
saving for the short term.
Short term savings is defined as saving for less than five years, so any interest gained will
be relatively low. If you want more interest and you can afford to wait awhile to get your
money) a year or more), then a money market mutual fund or CDs could be suitable.
These accounts usually are for higher interest rates than a savings account. Remember
though, that you may face penalties if you withdraw your money early from a CDs.
Saving over a short term is easy, it simply requires a small amount of determination and
discipline.
3.3
Reviewing and Revising
An element of financial planning that is often overlooked is time. Consider how your
income might have changed over the last ten years. Regardless of whether your income
has risen or fallen, the fact remains that it is very likely to be different than it was ten
years ago.
With this in mind, the process of constant review and revision becomes all the more
important. If you plan regular reviews six monthly, annually, every 5 years or weekly if
appropriate, you can keep track of where you are up to, and constantly assess your
changing financial position. In this lesson, you will learn that:
Financial planning is an ongoing process and that plans need to be reviewed.
You will also look at the various statements that you receive, and identify whether any
action needs to be taken to modify your plans in light of these statements.
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Review A Financial Plan
Financial planning is a continuous process. Review your plans regularly. If your goal is to
pay off your credit card bill, using your monthly cash surplus, then review your plan on a
monthly basis. However, if you have a long mortgage, then it would be inappropriate to
review your mortgage plan monthly. An annual, or even five-yearly review, would be
better.
Perhaps it’s a good idea to schedule reviews for all your financial plans at the outset. For
example, you could indicate on your budget sheet that a review is due on certain date;
that way you won’t forget it. If you do this you can be confident that all your financial
goals can be reassessed on a timely basis.
In financial terms, five year can be a very long time , and a lot of changes can take place;
your income could improve dramatically, you could purchase a new house, or get into
serious debt (though hopefully not). These changes should trigger a review of your plans;
that way you always be in the best possible position to make planning decisions.
Another time to review your plan is when new products become available. Governments
review their tax and saving programmes regularly, and governments like people to save
money, particularly where retirement is concerned. So, they develop incentive as time
passes. The same goes for banks and financial institutions.
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ACTIVITY-A
The Choice and decision making process
Identify the problem.
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Gather information and list possible alternatives.
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Consider the consequences of each alternative.
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Select the best course of action.
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Evaluate the results.
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Factor that can influence a decision
A. Values
What is important to your family, others in your culture?
B. Peers
People you know
Pressures that influence positive or negative behaviours
C. Habits
You are accustomed to doing it this way
D. Feelings (love, anger, frustration, ambivalence, rejection)
If you do make a certain decision
If you don’t make a certain decision
E. Family
Your family’s preference
Decisions other family members have made
F. Risks and consequences
What (or how much) you stand to win
What (or how much) you stand to lose
G. Age
Minor
Adult
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Common decision making strategies
Agonizing
Intention
Accumulating so much information that Choosing an option that will be both
analyzing
the
options
becomes intellectually and emotionally satisfying.
overwhelming.
Avoidance
Procrastination
Choosing the option that is most likely to Postponing thought and action until options
avoid the worst possible result.
are limited.
Compliance
Security
Going along with family, school, work, or
peer expectations.
Choosing the option that will bring some
success, offend the fewest people, and pose
the least risk.
Desire
Spontaneity
Choosing the option that might achieve the Choosing the first option that comes to mind;
best result, regardless of the risk involved.
giving little or no consideration to the
consequences of the choice.
Destiny
Synthesis
Letting outside forces decide; leaving the Choosing the option that has a good chance
decision up to fate.
to succeed and that you like the best.
Inspiration
Doing something because “it feels right” or
because “it just seems like the right thing to
do”.
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Economic influences on decision making
Before you make decisions about money, you must understand how economic factors may
impact personal and financial decisions.







Consumer prices
Changes in the buying power of the dollar, inflation
Consumer spending
Demand for goods and services
Gross domestic product (GDP)
Total value of goods and services produced within the country
Housing starts
The number of new homes being built
Interest rates
The cost of borrowing money
Money supply
Funds available for spending in the economy
Unemployment
The number of people without employment who are willing to work choices
Risk associated with decision making
Making choices about money can be risky. The following are common risks that you should
think about related to personal and financial decision making.
Income risk
Changing jobs or reduced spending by consumers can result in a lower income or loss of one’s
employment. Career changes or job loss can result in a lower income and reduced buying power.
Inflation risk
Rising prices cause lower buying power. Buying an item later may mean a higher price.
Interest-rate risk
Changing interest rates affect your costs (when borrowing) and your benefits (when saving or
investing).
Liquidity risk
Certain types of savings, guaranteed investment certificates (GICs), and investments (real estate)
may be difficult to convert to cash quickly.
Personal risks
These are factors that may create a less than desirable situation. Personal risk may be in the form
of inconvenience, embarrassment, safety, or health concerns.
Modules on Financial Literacy
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